The term “closing costs” is not new to you if you’ve bought a house before. Besides the expenses incurred by a real estate transaction (such as the loan origination fee, appraisal fee, etc.), closing costs also include some prorated expenses that are due to the buyer and the seller at the time of the closing.
A home sale rarely happens on the first day of the year – or even the first day of the month. By the time of closing, the original owner has likely paid some homeownership costs, such as taxes and HOA fees, ahead of time. The buyer must take over these expenses when taking possession of the property. Proration allows both parties to only be responsible for property expenses for the days they own the house.
Depending on the expenses, some may be paid in advance (for coverage that has yet to happen) or in arrears (for coverage that has already accrued.) Therefore, they will appear as debits or credits on each party’s closing statement.
What Expenses Get Prorated in a Real Estate Transaction?
Depending on the real estate transaction, several expenses may be prorated during a closing. Some of these costs are split between the buyer and the sellers, and others may be between the bank and the seller. Do not worry if math is not your strong point: your real estate attorney, real estate agent, lender, or escrow and title company do the proration calculations at the closing. They will give you a number before closing so you know exactly how much money to bring to the table. The closing disclosure usually has a detailed breakdown, too.
Real Estate Taxes
Property taxes are the most important item typically prorated during a real estate transaction since it is a significant cost of owning a home. When taxes are paid depends widely on the state and municipality: some may be prepaid, others collected in arrears. The time of the year when taxes are collected varies, as well.
The buyer and the seller must pay the appropriate amount of tax for the days they own the property. If the taxes are prepaid, the seller will receive a credit, and the buyer is charged. Taxes are prorated to the closing day since the original homeowner is responsible for paying them until the purchase is final.
It is not always a simple calculation: for example, the seller may qualify for exemptions that do not apply to the buyers, such as senior citizens or veterans. In addition, property taxes for rehab or new construction properties will need to be recalculated, as the original value the taxes are based on no longer applies.
Mortgage interest is due in arrears, and lenders collect interest up to 30 days before the first mortgage payment is due. For instance, if you close on April 5th, your first mortgage payment won’t be due until June 1st, and your lender will want to prorate the mortgage interest to cover the period from April 11th to April 30th. Therefore, most buyers owe mortgage interest at closing. It is also true for sellers who must pay interest when paying off their loans. Here is how to calculate the mortgage interest owed.
- Divide the annual interest by 12 to obtain the monthly interest.
- Divide the monthly interest by the number of days in the month of closing (typically 30 or 31) to obtain the daily interest.
- Multiply the daily interest by the number of days left in the month. For example, if you are closing on the fifteenth of a 30-days month, multiply by 15: the number obtained is the prorated interest that will be debited from your account.
Let’s look at an example. Say the annual interest comes out to be $4,800. Your closing date is April 11th, and your first mortgage payment is due on June 1st. To prorate the mortgage interest, you will
Homeowner Association Fees
Like taxes, the seller is only responsible for the homeowner association fee for the days they own the property. The timing depends on the billing cycle and the date of closing. If the HOA fees have not been paid yet, they will be paid from the seller’s proceeds. Divide the monthly by the number of days to obtain the day fee. In addition, there may also be a one-time HOA transfer fee – typically between $100 and $400 – paid at closing. The seller is usually responsible for this fee.
If the building being transferred is a rental property occupied by tenants, the closing fees may involve prorated rent. If tenants paid their rent at the beginning of the month, the seller owes the buyer any rent amounts that represent the period from closing through the end of the rental period (typically the end of the month.) For example, if tenants pay their rent on the first day of the month and the closing is on the 10th, the daily rental for the 20 remaining days (on a 30-days month) is a “credit” to the buyer and a “debit” to the seller on the closing statement.
Homebuyers typically take on new homeowners insurance and other hazard insurance (such as flood insurance) policies when buying a house. However, in some cases, the buyer may assume the seller’s insurance policy – for example, if the buyer is assuming the seller’s mortgage or buying on a contract for deed (or land contract.) Besides, in most transactions, the seller has likely prepaid for insurance for the entire month. They will receive a credit for any amount they have paid, covering days after closing.
In some rare cases, utilities may be prorated at closing.
In a typical real estate transaction, the seller will stop the property’s utility services before closing so the buyers can start with a clean slate. However, in some states, unpaid utility bills could become a lien on the property and thereby encumber the title. This situation could occur in the case of short sales or foreclosure when a homeowner in financial distress is more likely to fall behind on bill payments.
Besides, in some areas using oil as heating fuel, the sellers may have filled their tank before closing. Since the oil remaining in the oil tank is considered personal property belonging to the original homeowners, the homebuyers are often responsible for paying for any oil remaining in the oil tank at the time of closing and reimbursing the seller for the fair market value of the remaining oil.
Closing costs are a big part of a real estate transaction. By understanding how proration works, you can better prepare for the potential expenses you will incur during a sale so there are no surprises. While proration may seem complicated, the good news is your real estate agent, title or escrow company, and the lender will be able to calculate for you. Be sure to read through your closing statement and verify the numbers.
After graduating with a Master’s degree in marketing from Sciences Po Paris and a career as a real estate appraiser, Alix Barnaud renewed her lifelong passion for writing. She is a content writer and copywriter specializing in real estate and finds endless fascination in the connection between real estate, economic trends, and social changes. In her free time, she enjoys hiking, yoga, and traveling.